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It has been quite a stock market rally. Some now worry it could end soon, that the gains have extinguished the value once so evident in the stocks. That is very likely an overstatement. Stocks, though pricier than they once were, retain enough value to support further gains, even in the current mediocre economic and policy environment. Longer term, as the market realizes this remaining value, further gains will depend on more problematic, fundamental economic and policy improvements, but that date is probably 12–24 months away.
Stocks certainly have done well—remarkably, in fact, in the face of a poorly performing economy, severe policy failures at home and abroad, and intense investor caution, if not outright pessimism. From the lows of March 2009, during the last great recession, the S&P 500® Index has risen more than 100%, to its present level. During 2012 alone, S&P prices rose some 16%, and this year through mid-May, they have gained nearly another 16%.*
Two things have enabled those impressive price gains in the face of what looks like a fundamental disconnect on the economic and policy fronts. First and most obvious, the Federal Reserve has pumped a flood of liquidity into the financial system. Second is value. Stock prices and earnings were inordinately depressed when this rally began, even relative to the dire economic circumstances of 2008–09. At such values, price gains have had support even in the face of subpar economic growth and policy missteps here and abroad. The Fed’s success in keeping interest rates low made what was already good value look comparatively better. And remarkably rapid earnings gains earlier in this recovery, despite the slow recovery, reinforced the pricing response to already good value.
In the context of this history, looking forward, the rally would seem to have staying power, despite the price gains to date. Certainly, the Fed shows no sign of stemming the flow of liquidity, at least not anytime soon. Fed chairman Ben Bernanke talks about 2015 as the earliest date for the Fed to make any substantive policy shift, and even the most hawkish Fed officials talk about only the most gradual turn away from the present policy. At the same time, stock values, though not as drop-dead gorgeous as they once were, remain extremely attractive.
Longer term, however, the view raises questions. In the fullness of time, the Fed will have to adjust policy and allow interest rates to rise. To be sure, the Fed will almost surely move very gradually, but in time, the change will proceed, and it will affect markets. At the same time, likely further stock price increases will also tend to erase value, especially since the pace of earnings growth has already slowed. At present valuations, however, and the slow adjustment anticipated in bonds, the stocks would seem to have at least 15–20% more room to rise before even approaching a point when value would become questionable.
Risks to Consider: The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. No investing strategy can overcome all market volatility or guarantee future results.
The opinions in this publication are subject to change, may not reflect the views of the firm as a whole, and should not be relied upon by the reader as legal, tax, or investment advice. Information discussed is for educational purpose only and should not be considered a recommendation to purchase or sell securities. Readers should not assume that the securities depicted were or will be profitable. Consult a financial advisor on the strategy best for you based on your individual goals, investing time horizon, and risk tolerance.